As Benjamin Franklin once said, “in this world, nothing can be said to be certain, except death and taxes. ”The IRS recognizes realized capital gains whether or not you reinvest them. However, depending on your investment and how long the investment was held, there are strategies that investors can use to reduce or defer capital gains taxes through reinvestment.
Tax-Favored Retirement Accounts
Stocks, funds, as well as other securities, can be reinvested within an IRA, 401(k), or other tax-favored retirement accounts and can be purchased or sold without immediate tax consequences. As long as funds stay within the retirement account, transactions such as buying and selling stock, exchanges between mutual funds, capital gain distributions, and dividend reinvestments are not taxable. Once you start withdrawing securities from your retirement account, you’re subject to taxes and other penalties if you’re withdrawing before the age of 59 ½. Withdrawals are taxed as ordinary income.
With a Roth IRA account, considering contributions are added with after-tax dollars, and you can reinvest your capital gains without paying taxes. Unlike a regular IRA, qualified distributions won’t be taxed on investment gains. To benefit from a qualified distribution, the IRS requires taxpayers to be over the age of 59 ½ and be making withdrawals after a five-year holding period with certain exceptions such as a first-time home purchase, birth or adoption expense, or college expense. Withdrawals from a Roth IRA are tax-free as long as the rules for qualified distributions are followed.
Reinvesting through Real Estate
In a 1031 exchange, the taxpayer sells a business or investment property and replaces it with another qualified, like-kind property. Instead of recognizing the gain, all proceeds are reinvested into the replacement property. The IRS has strict rules used to qualify whether a transaction qualifies for deferment of capital gains taxes. Once a property is sold, and the taxpayer receives proceeds without doing an exchange, capital gains are realized and taxes must be paid.
Created by the Tax Cuts and Jobs Act of 2017, Qualified Opportunity Zones (QOZs) allow investors to reinvest without immediate tax consequences. Deferral of capital gains tax through reinvestment in a QOZ is permitted until December 31, 2026, and must be recognized before that date. Taxpayers can also benefit from reductions in tax liability. Funds held in a QOZ investment for at least five years before the end of 2026 can have a 10% reduction in the original capital gains tax liability. When investments are held for ten years, the tax basis increases to fair market value and erases capital gains tax within the QOZ.
Whether you’re trying to reduce or defer your capital gains tax liability, capital gains aren’t recognized until the asset is sold, and your best defense as an investor is to invest long-term. Working with a financial advisor and tax specialist is your best option to develop a strategy and to work towards your investment goals.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
The Investor's Cap Gains Guidebook
Re-invest your capital gains. Defer or Eliminate Taxable Income.